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Using Gift Money to Qualify for a Home Loan
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Using Gift Money to Qualify for a Home LoanDaniel Dobbs2025-03-12T18:02:07-07:00
It is common for many buyers to receive gift funds from a family member(s) to buy a home. How that gift is structured can be a sensitive family issue and a IRS taxable event.
Family baggage, sibling rivalries, legal and tax consequences need to be addressed between the giver and receiver, far in advance before the buyer begins searching for a property.
Any of these can derail a transaction and blow up all the time you’ve spent with your buyer.
Which begs the question of how to avoid the dreaded Gift Tax.
It’s important to structure the transaction properly to avoid paying that tax.
Example: Harold and Helen Smith (husband and wife) agree to split gift funds of $28K during 2017.
Harold gives his son George $14K, and Helen gives George’s wife (daughter-in-law) Gina $ 14 K.
Each gift is equal to the annual exclusion ($14,000), and by gift splitting, they can make these gifts without making a taxable gift.
Any additional monies over the $28k that the Smiths wish to give can be secured by a junior lien (i.e., 2nd T.D.) to protect a parent’s gift interest on behalf of their child.
For example, the Smith’s son may have married a young woman of questionable (in their eyes) long-term “economic viability” and “spousal capacity”.
In that case, The Smiths (who desperately want their grandchildren to grow up in a stable home environment) feel uncomfortable just handing over additional monies (because of community property laws).
So to protect their interests, they require the young couple to sign a 2nd Trust deed with themselves as the beneficiary at COE. This gives the “grandparents” some additional leverage in the event a divorce occurs, a child custody case erupts or the 1st TD teeters on verge of foreclosure.
Any family member can structure the gift as a loan and charge zero interest, but they may face unfavorable and complicated tax rules.
However, tax-law complications can be avoided by charging an interest rate that is at least equal to the applicable federal rate (AFR) approved by the Internal Revenue Service.
Current AFRs for term loans—meaning loans with a defined repayment schedule or a specific balloon-payment due date—are as follows (based on semiannual compounding):
A) 0.23% for “short-term” loans of up to three years.
B) 1.07% for “mid-term” loans over three years but not nine years.
C) 2.61% for “long-term” loans over nine years.
AFRs are updated monthly in response to ever-changing bond-market conditions. Each month’s AFRs are published in the Internal Revenue Bulletin (found at www.irs.gov).
The AFR rate is determined by the month when the loan is funded.
The “giver” (now the “lender”) must declare the interest payments received as income on their tax returns (Form 1040).
The “recipient” (now the borrower) can deduct the interest payments, provided the loan is secured by a home (via a second trust deed).
If the loan has a “demand feature” (as opposed to a specific “term”), the AFR isn’t fixed in the month the loan funds. Instead, it is floating and based on changing short-term AFR rates.
If the giver/lender makes an “interest-free loan” (“straight note”) the dreaded below-market interest rules may apply. If so, the giver AND lender MUST follow complicated rules to calculate imaginary interest payments.
To avoid this issue, both parties must put the loan in writing. Several online services, such as nolo.com, offer low-cost, do-it-yourself loan documents.
Lastly:
How the funds are received by your client MAY matter in the overall picture of this application process.
It’s best to give $$$ whenever possible, which should then be deposited into the recipient’s account well before the deal is initiated.
Here’s why:
1) You know you have a “live” transaction. Gift givers have been known to have second thoughts, so let’s ensure that if they “pull the rug out” from the buyer, it’s before the agents do all the hard work.
2) Those funds can be used to address any credit issues (low scores and debt negotiation/reduction resolution) in advance.
If debts need to be paid off and credit scores raised, it’s best to do so before entering escrow and instead of being under the gun while deadlines expire.
(A downside is the “loving young couple” may decide to blow all part of the $$$ on something besides the home purchase).
3) Simplicity No actual gift letter forms need to be completed or paper trail of $$$ need to be provided.
4) When an underwriter reviews a loan application, the U/W is really judging a borrower’s overall viability and strength.
For example, if your buyer/borrower has a high “Debt to Income” ratio (DTI) or marginal credit scores (under 640), the borrower will appear stronger IF the funds have been “seasoned.”
This impression can make the difference between us earning a commission or NOT!
To “season” a gift $$$, the funds must have been in the recipient’s account for typically 61 days or as long as 89 days, depending on the cycle date of the bank statement.
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